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Sugar Rally has Become Overextended

The sugar market has been one of the few bright spots in the commodity futures. Since most commodity exposure is long only and this market has rallied between 45%-50% since bottoming in late August it has become a commodity darling. There are three primary reasons for the recent rally. Of these, only one is structural. We feel the the transitory nature of the other two will conspire to bring prices back down as the #11 sugar futures tighten their link to domestic prices in the primary growing regions.

Beginning with the macro situation and working our way down to the micro trading opportunity, we begin with the fundamental shift in the sugar futures from supply surplus to supply deficit. The combination of high oil prices, driving high ethanol prices in accelerating economies pushed sugar farmers to increase output as much as possible. This was especially true in Brazil which is not only the largest cane grower but, also predictably, the number one user of sugar based ethanol which, is far more efficient than the corn based ethanol we produce domestically. Not coincidentally, these prices peaked during the 2011 commodity boom. Since then, the ensuing economic collapse has left the sugar market oversupplied for years on end. This balance has finally begun to shift with 2016 expected to be the first deficit year in ages. Therefore, there is some fundamental support going forward. However, this support is being offset by the decline in the Brazilian Real as well as the ongoing slump in the petroleum sector which diminishes ethanol demand.

The first of the transitory issues is weather related. While normally, this would be the most transitory of the issues affecting the market, the strongest El Nino effect on record places its importance higher in the order. We've covered the expected effects of this phenomenon in detail. Citing our own work from, El Nino and the Global Grain Markets, ”The phenomenon can alter established weather patterns in different parts of the world, bringing severe drought to parts of Asia while at the same time bringing heavy flooding to some parts of North America.” Brazil is already experiencing weather issues with not enough rain in the northern parts which will diminish sugar content in the cane to be harvested along with too much rain in the southern parts which is already impacting the current crop's harvest. Furthermore, weather patterns are beginning to be affected throughout Asia, including India, Thailand and China. When it comes down to it, sugar is like trading any other crop; weather fears push prices upwards.

The final piece of the recent rally has been investment purchases through commodity funds. We've saved this for last since these actions are fueled by the expectations of the previous two points. In the first chart below, note the periods of bullishness and bearishness. Bullish periods are identified on the weekly chart as periods when the commercial traders, in this case, the end line processors and consumers control a larger portion of the long open interest than do the commodity funds. Meanwhile, bearish periods are noted by the wide disparity between commodity investment managers' purchases versus the forward selling of sugar producers. It is quite clear sugar producers are far less bullish about the price of their current crop than are the commodity investment managers.

The commercial traders in the sugar market are far more successful than their commodity investment managers' counterparts.

We scale this activity down to the daily level for the purposes of our own trading. The chart below includes the setups and triggers over the last couple of years. The sugar market has become, temporarily overbought, based on weather fears and direct investment in commodity futures. However, subsidized sugar producers in the world's dominant growing areas are using these same concerns to sell their forward production at a rapid pace. Therefore, while the world's supply and demand balance may be shifting from surplus to deficit, we believe the current short-term trading opportunity lies on the sell side.

The daily price action in the sugar futures with our Commitment of Traders overlay shows how the previous examples worked out in actual trading.

We've sold the March 2016 #11 sugar futures contract and expect it to return south of $.12 per pound. We'll also stay abreast of possible deteriorating weather conditions due to El Nino even though the historical implication suggests it's misplaced fear. Meanwhile, we watch as the commodity investors and the commercial traders duke it out as the market rediscovers its value area while shifting from surplus to deficit over the long haul.

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